If you are a conservative investor venturing into equity, balance funds can be a good choice

Ritu Arora, a 33-year-old Gurgaon-based corporate communication professional, has been investing in bank fixed deposits, the Public Provident Fund (PPF) and traditional insurance products. Now, she wants to build a corpus for her six year-old daughter's higher education, a goal that is 15 years away. When her friends suggested diversified equity funds, she was aghast at the thought of investing in volatile equity. However, a visit to a financial planner, who advised balanced funds, resolved the issue. Such funds typically invest 65-75% of their portfolio in equity, and the balance 25-35% in bonds. The planner advised that while the long-term nature of her goal justified an investment in equity, the debt component would make these funds less volatile.

Like Arora, many conservative investors are turning to balanced funds, which are in a sweet spot currently. Equity is trading at a discount to long-term averages. On the debt side, interest rates appear to have peaked and are likely to either remain at these levels or fall. Hence, a hybrid instrument, which gives you access to both equity and debt in a tax-efficient manner, should find many takers

Even from a defensive point of view, balanced funds are well-suited to moderate risk takers. "In times of uncertainty, balanced funds are better suited as they offer diversification into different asset classes within a fund. While equity boosts portfolio returns during market upswings, debt contains the impact of a major fall in the equity market.

THE BENEFITS

Less volatile: Balanced funds are less volatile than diversified equity funds. First-time investors especially can't handle the volatility that comes with a 100% equity investment. The 25-35% allocation to bonds reduces volatility and allows them to cope better with the emotional and behavioural challenges of investing in equity.

Automatic rebalancing: With balanced funds, you don't have to bother about maintaining your portfolio's asset allocation. The fund does it on your behalf. Investors who lack the discipline to rebalance their portfolios periodically, or for behavioural reasons find it difficult to purchase an asset class that is underperforming, should invest in balanced funds.

Tax advantage: As balanced funds keep their equity allocation above 65%, the investor's entire investment is treated as equity for tax purposes and is exempt from long term capital gains tax. Even the debt portion gets a favourable treatment. If, on the other hand, you invest in two separate funds, equity and debt, you will have to pay tax on long-term capital gains in case of the debt fund.

Asset allocation: Balanced funds handle the task of tactical asset allocation (making a limited change to your strategic or long-term asset allocation based on your market outlook) on your behalf

The investor gets the advantage of the fund manager's expertise in allocating assets on his behalf. If the equity markets fall and valuations become attractive, he increases the allocation to equity. If they become overheated, he maintains a higher allocation to debt.

Mid- and small-cap stocks: The fund manager also takes a call on increasing or decreasing allocation to mid- and small-cap stocks. "The fund manager has the flexibility to use a few mid- and small-cap stocks, especially when they are beaten down. In certain market phases there is absolute apathy for mid-caps and small-caps. This allows the fund manager to create alpha even with limited exposure to these stocks.

The Drawbacks

Poor returns in rising market: In case of an upswing in the market or a bull run, balanced funds' returns may be lower than that of pure equity funds as their equity component is lower.

Rebalancing: It becomes more complicated to rebalance if you have balanced funds along with pure equity and debt funds in a large portfolio. So, if you have four equity funds and two debt funds, you can easily calculate their weights in the portfolio on the basis of the number of units and NAVs of each fund. Since balanced funds are multi-asset products, you have to dig deeper and find out the weightage of equity and debt in the portfolio at a given point.

Lacklustre performance: Even balanced funds flounder in certain market conditions. First, when interest rates are rising, both equity and debt instruments perform poorly. Second, when there is a high degree of stress in the macro-economic environment, equity performs poorly as investors turn fearful, while corporate bonds underperform due to fear of default. However, remember that in adverse equity market conditions balanced funds are likely to fall less than pure equity funds.

Watch out for…
Here are some of the risks that a balanced fund may incur. One, the fund manager's equity allocation may be on the higher side. Two, he may venture heavily into mid- and small-cap stocks. Three, on the debt side, the fund manager may take duration risk. Four, he may take excessive credit risk in the debt portfolio. Hence, look closely at a balanced fund's portfolio before investing in one.

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